Guide to Consumption Tax

By Timothy Moore · October 18, 2023 · 7 minute read

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Guide to Consumption Tax

A consumption tax is a tax on a specific good or service. When you pay sales taxes on retail purchases, gasoline, and alcohol, you’re paying a consumption tax. Businesses also pay consumption taxes, like when exporting goods to another country (i.e., paying that country’s import taxes).

But that’s just an overview. Here, you can learn more about these taxes and how they impact you, including:

•   What is consumption tax?

•   How do consumption taxes work?

•   What are the different kinds of consumption taxes?

•   What are the pros and cons of consumption taxes?

•   What’s the difference between consumption taxes vs. income taxes?

What Are Consumption Taxes?

Consumption taxes are a broad range of taxes that are imposed when you spend money on a good or a service. A common example is a sales tax since consumers are used to paying this with most transactions. However, there are other consumption taxes that affect businesses, as well as ones that are in place in other countries.

The key tenet of a consumption tax is that taxpayers are charged based on what they spend, not what they earn, which makes them different from income taxes. In some countries, including the U.S., consumption taxes and income taxes coexist — along with other types of taxes.

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Types of Consumption Taxes

Here are some of the most common types of consumption taxes you might encounter:

•   Sales tax: When you pay for goods or services at stores, restaurants, and other businesses, you typically pay a sales tax. All but five states have a state-wide sales tax, and individual localities can impose their own sales taxes.

Of those five tax-free states — Alaska, Delaware, Montana, New Hampshire, and Oregon — only one has localities that charge a sales tax: Alaska. States without income taxes often (but not always) have high sales tax rates.

•   Excise tax: An excise tax is seemingly similar to a sales tax, except it’s levied on specific purchases. Colloquially called “sin taxes,” excise taxes are often imposed to discourage certain behaviors that society may see as detrimental in some way. For example, there are excise taxes on alcohol, cigarettes, betting, and even tanning salon services.

Excise taxes also refer to specific taxes that support our infrastructure, like taxes on gasoline and air transportation. Depending on the excise tax, it might be levied on the manufacturer, retailer, or consumer. Often the taxes are rolled into the price a consumer pays: For instance, the excise tax on gas could be passed along to you without your even knowing it.

•   Value-added tax: Commonly referred to as VAT, value-added taxes are not implemented in place in the United States. Instead, you may encounter these when traveling to Canada or Europe. This flat consumption tax is levied on a product at each stage of production where value is added to it, but the cost of the tax is ultimately passed on to the person who purchases the final product.

The consumption taxes above impact individual taxpayers. Businesses may contend with another type of consumption tax: import duties.

Recommended: How to Reduce Taxable Income

How Do Consumption Taxes Work?

Now that you know what consumption taxes are, take a closer look at how they function. Consumption taxes work a little differently from one another depending on their type. Sales tax, for example, doesn’t appear until the final point of sale, while VAT is applied throughout the production process.

Regardless of the type of consumption tax, however, the fundamental principle remains the same: You pay taxes when you spend money on goods and services, rather than when you earn the money.

Pros and Cons Consumption Taxes

So what are the pros and cons of consumption taxes? Let’s break it down:

•   Pro: Consumption taxes can be easier to calculate. A flat sales tax that everybody pays when they make a purchase is quite straightforward. It’s easy to calculate. You are probably accustomed to that sales tax, for instance, that gets added on as you check out in a store.

This is in stark contrast to taxes that can be complex to figure out. For instance, income can be difficult to measure when filing taxes, especially when you consider wages, tips, self-employment income, capital gains, interest, dividends, and so on. (No wonder so many people seek help during tax season.)

•   Con: A consumption tax puts a heavier tax burden on low-income earners. The United States has a progressive income tax system. What that means: The more money you earn, the larger the percentage of your income you must pay in taxes. Some believe this is the right thing to do; they argue that high-income earners can afford to pay more in taxes while low-income taxpayers may be living paycheck to paycheck.

However, with consumption taxes, everyone can be taxed at the same rate, which could be problematic for low-wage earners. In other words, the person who earns $20,000 a year pays the same sales tax rate as the person who earns ten times as much.

•   Pro: Consumption taxes may encourage saving. For individuals who are struggling to reign in their spending habits, a larger consumption tax — levied every time they swipe their credit card — may encourage them to spend less and save more money.

•   Con: Consumption taxes could discourage spending. But if fewer people are encouraged to spend because of higher consumption taxes, the economy could suffer.

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Consumption vs Income Tax: What’s the Difference?

So what’s the main difference between consumption taxes and income taxes? Much depends on when the tax is levied.

•   A consumption tax is levied when you spend the money (i.e., when you consume a good or service).

•   An income tax is levied when you earn the money (usually through tax withholdings from a paycheck and quarterly estimated payments) or when you receive interest, dividends, or capital gains.

The Takeaway

A consumption tax refers to a broad range of taxes, including sales taxes, excise taxes, and value-added taxes. These are charged on goods and services and can be a key sources of revenue for states. Unlike income taxes which are charged on income, consumption taxes are levied when a consumer or business spends money.

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FAQ

Can you deduct consumption tax?

If you itemize your deductions, you can take the SALT (state and local taxes) deduction on your state and local income taxes or your state and local sales taxes, a form of consumption tax. Doing so would require receipts from every purchase or an estimate using the IRS’s optional sales tax tables.

Do you have to put consumption taxes on your yearly taxes?

If you choose to apply the state and local sales tax (SALT) deduction when itemizing deductions on your taxes, you would include your consumption taxes on your tax return. Businesses should also list their consumption taxes as a business expense to reduce their taxable income.

How much do people spend on consumption taxes on average?

How much people spend on what is known as consumption taxes will depend entirely on where they live and how much they spend on purchases each year. Sales tax, for example, varies widely across the United States; in some states, it’s 0% while in others, it’s 7% or more.

Because consumption taxes are levied when consumers make purchases, their total consumption taxes in a given year also depend on the number of purchases they make. Certain items like gas and alcohol have specific excise tax rates, different from regular sales taxes, that can make it even more complicated to estimate.


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